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Buy value stocks

One conclusion that financial researchers have convincingly drawn is that value stocks outperform growth stocks in the long run.

Value stocks are those that are expected to grow slowly, and typically have a low share price compared with their present earnings (i.e. low Price to Earnings ratio) – this is because investors expect their profit to grow slowly or not at all. Growth stocks have high share price relative to their present earnings – because investors expect their profit to grow rapidly. You can earn above average returns if you correctly identify low PE stocks, whose earnings eventually grow faster than expected.

Buy companies in low growth industries, which are likely to cut their costs seriously. When there is little room to increase revenue, the clear alternative is to cut costs. Many well-performing banks such as Wells Fargo (in US), National Australia, and Lloyd’s (in UK) saw a lift in their share price because of this approach. They then leveraged their expertise by taking over high cost operators.

Get in when you hear high cost operators taking a knife to their costs – useful news might be that the company has hired management consultants, formed an internal task force, or retrenched staff.

Caveat: eventually, the players will run out of acquisition opportunities, and their stocks falter.

Buy low PE companies that can leverage their business system with a related product.

Example: Beer companies added wine through their distribution and marketing systems in the 1990s and early 200s. Beer consumption had been stagnating in developed economies; brewers had solid cash flows but not much to do with them. In contrast, table wine consumption had been increasing, and wine production in the southern hemisphere and North America had grown solidly. Fosters, the Australian brewer changed its growth outlook first buying a wine maker in its home ground, then a wine maker in North America, in the process transforming itself into an international alcoholic beverage player. Its share price rose from about A$1 in 1990 to above A$4 in 2000. A similar story happened with Lion Nathan, which saw its share price rise from about $3.50 to $6.00 between 2000 and 2003.

Buy low PE companies with underutilized assets. If some assets are not used, focusing on earnings alone would ignore the value of these assets. If the PE is low, observers may have overlooked these assets. Sometimes this happens to manufacturing companies with excess land, mining companies with unnoticed reserves, or development companies with a large land bank.

Understand logical reasons why PE might be low One reason could be the stock is in a cyclical industry. When investors expect commodity prices in these industries to decline in future, the stock price may not represent fair value.

Caveat: nothing is certain. Theoretically, if current investors suddenly flock to low PE stocks, these stocks would rise in price and no longer represent good value. Future returns would then not exceed the market average.